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SUBCONTRACTOR DEFAULT INSURANCE – Kyle W. Ohlenschlaeger and Bruce E. Loren | Oct 15 2019

We recently received a few inquiries from general contractors regarding subcontractor default insurance ("SDI"), asking how it works and whether it is a viable alternative to subcontractor payment and performance bonds. There is a two-part answer. First, SDI is NOT an alternative to subcontractor payment bonds as it does not provide for any recovery if a subcontractor fails to pay its sub-subcontractors or suppliers. Second, while it may be an alternative to subcontractor performance bonds, we believe that performance bonds are, in most cases, a better product for our clients.

SDI is a type of insurance obtained by the general contractor, not by subcontractors. In a broad sense, it provides coverage to its insured general contractor in the event a subcontractor is terminated for default or abandons work on a project. Upon default and abandonment, the SDI will pay costs associated with the default, subject to deductibles and co-pays by the insured general contractor. SDI has two main benefits as compared to subcontractor performance bonds: (1) the premium is usually lower than the cost of a subcontractor performance bond; and (2) upon default, there is no down time for the surety to investigate the claim – the insurance just kicks in, often minimizing delay to the project. However, in our opinion, these benefits do not outweigh the risks to SDI. It helps to compare some of the primary differences in the features of SDI and subcontractor performance bonds:

    1. Underwriting/prequalification: Subcontractor performance bonds are underwritten by a surety, who conducts a detailed evaluation of the financial condition of the subcontractor to determine if they are qualified and financially able to perform the work. Under SDI, the prequalification is done by the general contractor. This creates added burden on the general contractor before the project even starts and, despite the general contractor’s best efforts, a surety’s underwriting process will almost always be more thorough. As a result, the general contractor can rely upon the surety’s underwriting process to hire qualified subcontractors.
    2. Cost: The principal payments under SDI policy will likely be less than the cost of a subcontractor performance bond. Therefore, if the subcontractor does not default on the project, the overall cost will be lower and the general contractor can secure higher margins. However, SDI generally includes high deductibles and co-payments. Subcontractor performance bonds, on the other hand, will cover the entire cost of a subcontractor default (up to the amount of the bond). Therefore, the general contractor will have higher exposure under SDI if the subcontractor default.
    3. Subcontractor Incentive: Surety companies require a guaranty and indemnity agreement from both the subcontractor and the subcontractor’s principals, but SDI does not. Therefore, the subcontractor and its principal’s have skin in the game if they default on the project that is subject to a performance bond. Under SDI, a subcontractor’s principals can avoid any personal liability for a default, thus giving the subcontractor less incentive to complete its work.
    4. Completing the Subcontractor’s work: Under a subcontractor performance bond, the surety steps in to pay for, manage and complete the subcontractor’s work. Under an SDI policy, the general contractor manages and pays for the completion of the subcontractor’s work, submitting documentation to the insurance company and requesting reimbursement for amounts paid. Though this minimizes delay to the project, it requires more effort on the general contractor’s behalf and necessarily requires the general contractor to pay for the cost of completion up front.
    5. Exchange of Information: As indicated above, the general contractor is required to undertake the prequalification of its subcontractors under SDI. To properly complete the prequalification process, the general contractor will need to obtain sensitive financial information from the subcontractor, who may not feel comfortable exchanging that information. This apprehension does not exist under a subcontractor performance bond because the subcontractor maintains a confidential relationship with its surety.
    6. Acceptance: Surety bonds are universally accepted by owners. Because the details of SDI are less known, many owners (including municipalities, states, and the federal government), are not comfortable substituting a performance bond with SDI.

Because of the differences outlined above, we believe that requiring subcontractors to obtain performance bonds is a better alternative to SDI. That does not mean we would never recommend SDI, as there may be instances where it is appropriate. If a general contractor is intent on using a subcontractor that otherwise cannot obtain a bond, it can minimize project risk by obtaining SDI coverage. Except for a few exceptions, we recommend the known commodity—subcontractor performance bonds—to our general contractor clients that are looking for the best product to reduce the risks of subcontractor default.

Bruce E. Loren and Kyle W. Ohlenschlaeger of the Loren & Kean Law Firm are based in Palm Beach Gardens and Fort Lauderdale. Loren & Kean Law is a boutique law firm concentrating in construction law, employment law, and complex commercial litigation. Mr. Ohlenschlaeger focuses his practice on construction law and a wide range of commercial litigation disputes. Mr. Loren has achieved the title of "Certified in Construction Law" by the Florida Bar, exemplifying the Bar’s recognition of this expertise. The firm’s construction clients include owners/developers, general contractors, specialty contractors in every trade, suppliers and professional architects and engineers. Mr. Loren and Mr. Ohlenschlaeger can be reached at bloren@lorenkeanlaw.com or kohlenschlaeger@lorenkeanlaw.com or 561-615-5701.